Kamis, 19 April 2018

Buybacks redux

Two more points occur to me regarding share buybacks. 1)When buybacks increase share prices, and management makes money on that, it's a good thing. The common complaint that buybacks are just a way for managers to enrich themselves is exactly wrong. 2) Maybe it's not so good that banks are buying back shares.  3) The tax bill actually gives incentives against buybacks. What's going on is despite, not because.

Recall the example. A company has $100 in cash, and $100 profitable factory. It has two shares outstanding, each worth $100. The company uses the cash to buy back one share. Now it has one share outstanding, worth $100, and assets of one factory. The shareholders are no wealthier. They used to have $200 in stock. Now they have $100 in stock and $100 in cash. It's a wash.

Why do share prices sometimes go up when companies announce buybacks? Well, as before, suppose that management had some zany idea of what to do with the cash that would turn the $100 cash into $80 of value. ("Let's invest in a fleet of corporate Ferraris"). Then the stock would only be worth $180 total, or $90 per share. Buying one share back, even overpaying at $100, raises the other share value from $90 to $100.

That was the big point. Share buybacks are a good way to get money out of firms with no ideas, into firms with good ideas. We want firms to invest, but we don't necessarily want every individual firm to invest. That's the classic fallacy that I think it turning Washington on its head. Best of all we want money going from cash rich old companies to cash starved new companies. Buybacks do that.

1) Management getting rich on buybacks is good.

OK, on to management. Management, buyback critics point out, often has compensation linked to the stock price. They might own stock or own stock options. So when the buyback boosts the stock price, then management gets rich too. Aha! The evil (or so they are portrayed) managers are just doing financial shenanigans to enrich themselves!

The fallacy here, is not stopping to think why the buyback raises the share price in the first place. If it is the main reason given in the finance literature, that this rescues cash that was otherwise going to be mal-invested, then you see the great wisdom of giving management stock options and encouraging them to get rich with buybacks.


There is a strong incentive to keep the money in the firm and invest it on lousy projects.  What CEO wants to say "we didn't have any good ideas, so we gave the money back to shareholders!" No! Build solar-powered spaceships to the mars colony! This, in fact, is the classic "agency" problem that managers are prey to: using corporate cash in unprofitable expansions and investments that make the CEO look good but lower the value to shareholders. And now politicians chime in and want you making even worse investments, and excoriating you for giving shareholders back some of their money.

What we need here is... a nice incentive for management to pay out money rather than invest it badly inside the company. And stock price linked pay does that nicely, doesn't it!

Again, the stock price wouldn't go up if the money was going to be invested well in the company. The  stock price incentive nicely balances the empire-building incentive.

2) Maybe not for banks.

The other reason companies buy back shares is to lever up  more. Suppose our company had $100 of loans as one asset, and $100 of cash from its great trading profits as the other. If it buys back a share for $100, and simultaneously borrows $100, keeping the cash, it turns from a 100% equity financed firm to a 50% leveraged firm.  Banks are already 90% leveraged.

Why would a company do that? Well, debt is cheaper because the government bails out debt in bad states of the world. (Wave hands about MM violations).

The financial system fell apart because banks were incredibly over-leveraged. A battle royal has gone on for 10 years to get them to raise more money from equity. They complain "agency costs, we can't issue more equity!" They complain "Our investors are morons, we can't stop paying dividends." OK, but we don't have to let them buy back shares that are already outstanding!

Again, look always for the economic reason for things. If companies are using cash to buy back shares because they don't know what to do with the cash, great. If banks are buying back shares and substituting debt which is artificially cheaper, and brings us back closer to a financial crisis, then not so good.

3) Tax incentives.

Managers and shareholders face a decision: Leave "cash" -- earning interest -- inside the firm, or invested by the firm in other stocks? Or pay it out to shareholders. If you leave cash inside the firm, investors don't pay dividend or capital gains taxes on it right away. But they do pay the corporate tax. So reducing the corporate tax rate to 21% (plus state) from 35%, while leaving individual taxes alone, is actually a pretty big change in incentives toward leaving money inside the company.

I'm a corporate finance and tax  amateur, so comments from that quarter are always welcome.